Global Shadow Banking: Facts, Issues and Opinions

This week a new report released by top regulatory group the Financial Stability Board (FSB) revealed that the global ‘Shadow Banking’ industry reached a new all-time high of $67 trillion last year.

The FSB, an international task force put together jointly by the world’s top 20 economies, called for improved regulation to control the activities of the shadow banking industry, which is blamed by many for contributing to the current global economic crisis and for hiding fraudulent activities by large multinational companies. These calls come in the same week as technology giant Hewlett-Packard launches a fraud case against the previous owners of one of their acquisitions (Autonomy), over more than $5 billion worth of fraudulent accounting.

What is Shadow Banking?

“The shadow banking system is the collection of non-bank financial intermediaries that provide services similar to traditional banks…The core activities of investment banks are subject to regulation and monitoring by central banks and other government institutions – but it has been common practice for investment banks to conduct many of their transactions in ways that don’t show up on their conventional balance sheet accounting and so are not visible to regulators or unsophisticated investors. For example, prior to the financial crisis, investment banks financed mortgages through off-balance sheet securitizations and hedged risk through off-balance sheet credit default swaps.” – Wikipedia

To put this in plain English for you: shadow banking is the art of hiding things. By adding additional layers of complexity things which would otherwise be clearly visible in a company’s accounts can be conducted ‘off-balance sheet’. This can be used to make things invisible to anyone who is unfamiliar with the specific techniques being used so that you can, for example, misrepresent the value of a company to a potential buyer or investor. It can also be used to game the system, allowing banks and companies to circumvent regulations and international laws. To be clear: shadow banking is not illegal and does not involve illegal practices – it involves circumventing legal requirements so that the institution involved does not break any laws, but does not need to abide by them either. For example, since the global ‘credit crunch’ there are now laws which require banks to hold a certain amount of capital relative to the amount of money that they lend; by taking a loan and selling it to another company (a company which is not a bank and therefore doesn’t face the same legal restrictions as banks), then buying it back packaged up as a derivative which can be classed as an asset rather than a liability, the bank can effectively ignore the rules which national and international bodies have tried to impose on it.

In defense of some practices currently labelled as ‘shadow banking’: Part of the increased risk mentioned above is moved off the balance sheets of banks into hedge funds, investment funds and the like, which do not hold customer deposits, and is not returned to the banks. As long as these organisations are not ‘too big to fail’ (which many are btw) this may actually reduce risk to customer deposits. . Although these organisations are part of the shadow banking system, I do not think it is helpful to simply label everything they do as ‘shadow banking’. Personally, I would call for a more nuanced approach to definition of the term.

The Growth of the Global Shadow Banking System

The world shadow banking system began growing rapidly around the year 2000. Between 2002 and 2007 it doubled in size, reaching $62 trillion. Following the start of the financial crisis in 2008 it briefly contracted, before beginning to grow rapidly again. The FSB report mentioned above showed that by 2011 it had reached $67 trillion US dollars. To put that in perspective, $62 trillion is larger than the total economic output of all of the world’s top 20 economies, who make up the FSB group. The largest portion of this international industry in located in the United States of America ($23 trillion), however the size of the industry in America is shrinking, whereas it is growing rapidly in the Eurozone ($22 trillion) and the United Kingdom ($19 trillion).

Global Financial Risks Caused by the Shadow Banking Industry

Shadow banking practices increase systemic risk within the world banking system and the broader global economy as a whole. They do this by increasing leverage (debt and risk) beyond the levels which traditional banks are legally allowed. This risk is then passed back to the traditional banking system. By allowing large financial institutions to effectively ignore regulations which are imposed on them, this industry makes it very difficult for national government and international institutions to take the necessary measures to prevent the occurrence of events such as the 2008 credit crunch and ensuing international recession. To put it as simply as possible – shadow banking makes another global financial crisis more likely, and leaves governments powerless to address this risk.

The 2008 financial crisiis provides an excellent example of the risks posed by this industry, as many claim that growth of the shadow banking system from 2000 up until 2008 was the main cause of the crisis.

Economist Paul Krugman described the run on the shadow banking system as the “core of what happened” to cause the crisis. “As the shadow banking system expanded to rival or even surpass conventional banking in importance, politicians and government officials should have realized that they were re-creating the kind of financial vulnerability that made the Great Depression possible—and they should have responded by extending regulations and the financial safety net to cover these new institutions. Influential figures should have proclaimed a simple rule: anything that does what a bank does, anything that has to be rescued in crises the way banks are, should be regulated like a bank.” He referred to this lack of controls as “malign neglect.” – Wikipedia

Shadow banking practices also increase the risk of fraud and reduces investor confidence, and are related to the practice of tax avoidance.

Is Anything Being Done About It?

Regulating the shadow banking industry is an inherently difficult proposition, because the industry itself can be defined, at least in part, as the ongoing (and highly creative) attempts by banks and large companies to hide what they are doing from regulators. Nevertheless there have been a number of recent initiatives designed to bring the main parts of today’s shadow banking industry into the regulatory framework.

In 2010 the United States passed the Dodd-Frank Act,which stipulates that the Federal Reserve System will now have the power to regulate all institutions deemed to be of systemic importance, rather than just banks, that hedge funds with assets over $150 million must be registered, and that most over-the-counter derivatives trades must go through exchanges and clearing houses.

The FSB has made shadow banking regulation its number one priority, and will submit a report to the G20 by the end of 2012.

The European Commission is due to announce new EU-wide regulations to tackle shadow banking in 2013.